In 2019, the average IRS tax refund was $2,729, down slightly from 2018’s average of $2,788, according to the IRS. And while many people treat their tax returns like “found money” and use them to splurge, there are smarter ways to use your unexpected windfall, says certified financial planner Mari Adam of Adam Financial Associates in Boca Raton, Fla.
She recommends putting your tax refund into a Roth individual retirement account (IRA), a retirement savings account that allows you to earn tax-free returns over an extended period of time. Unlike a traditional IRA, Roth IRAs provide no tax break for contributions, but earnings and withdrawals are generally tax-free at retirement time. It’s one way to use your federal tax return to save money and give your future self a bonus.
“By saving a little in your Roth IRA when you’re young, you can make big strides by the time you retire,” she says. She notes that setting aside your savings in a traditional or Roth IRA makes you less likely to take the money out and spend it, which might be tempting to do if you simply leave it in your checking account. You can contribute up to $6,000 per year to a Roth IRA—$7,000 if you’re over the age of 50, though the maximums may be lower depending on your income. You should consult your tax advisor before you contribute to an IRA to make sure you fully understand your situation.
If you still have money left over from your income tax return, Adam suggests paying down credit card debt, buying term life insurance if you have a young family, and making an extra mortgage payment. “Some clients have used tax refunds for home improvements or to finance a new car,” she adds. “And these are all great options, if you’ve addressed the higher priorities first.”
But next year, she advises people to aim to not get a refund. As thrilling as it is to receive a sudden infusion of cash every spring, what a tax refund actually means is that you’ve given the government an interest-free loan for an entire year, says Adam. That’s money that could have been earning you interest in a high interest savings account, money market account or CD.
If you’re a salaried employee, update your W-4 form, which tells your employer how much tax to withhold. “That’s especially important to do now, since recent tax cuts mean the rates and withholding tables have changed,” Adam adds.
Your tax preparer can also help advise you on how much to withhold or pay during the year in order to avoid a refund. Tax filing software will also calculate this for you. People whose income is variable, who rely on tips or commissions, or who are independent contractors may have a harder time estimating future tax bills and may want to consult an accountant first.
Maridel Reyes is a journalist based in New York. Her work has appeared in Forbes, Bloomberg Businessweek, the New York Post, USA Today and the Boston Globe.
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